MF Global May Have Used Customer Funds In The Losing $6.3 Billion Trade Without Informing Clients

Robert Lenzner
, ContributorOpinions expressed by Forbes Contributors are their own.

After an intense day of investigation, I have just discovered that a CFTC rule(1.29) allowed Jon Corzine's MF Global to use the margin and cash in customers heretofore segregated accounts to amass a risky $6.3 billion investment in European sovereign debt that backfired. Nor did Corzine have the obligation to inform any of these customers he was gambling with their money. Or that he was intending to keep all the profits for himself and his troubled firm. Nothing for the customers.

The language of Rule1.29 allows "The investment of customer funds in instruments described in 1.29 shall not prevent the futures commission merchant (MF Global) or clearing organization so investing such funds and retaining as its own any increment or interest resulting therefrom." Increment refers to any trading profits or gains.

The criminal division of the Justice Department in New York -- as well as the SEC and the CFTC and members of Congress-- are investigating whether any laws were violated and if so, whether any criminal charges can be brought. As of 3pm today, there has been no sign of the missing $633 million. My sources believe it was probably grabbed by the institutions that made the margin calls on MF Global as the European bonds sank in value.

This shocking loophole, which is available to all commodity traders, whether giant ones like Goldman Sachs or members of commodity exchanges, means that huge risks are being taken with money that does not belong to the trading firms-- without the customers having any idea of the danger they are in. As Andy Abraham, a futures trader in Israel put it to me today; "this means they can take segregated funds and leverage them to kingdom come. It means nothing is safe."

This rule, which has been in effect since 1974, is shocking and highly irregular since it allows any futures dealer to use customers money for its own selfish purposes-- and never inform its customers it is doing so. What's even more unfair is that the dealer(MF Global) gets to keep all the income and the trading profits, if any from a transaction that uses other people's money-- not its own house capital. That is unless some prior arrangement about sharing profits was made privately beforehand with the client. None of the MF Global clients I've spoken to today had the foggiest notion about this arrangement-- which at minimum is outrageously unfair to the rule that the customer comes first. All losses must be made up by the dealer, which in this case may be totally impossible.

As a federal government official explained to me today; "certain kinds of transactions don't have to be communicated to the customer." So Andy Abraham and dozens of others were left completely in the dark about how their money was being used. They had no idea rule 1.29 existed and that the FCM, MF Global "gets all the income and all the profits, and bears the losses which have to be made up in the customer's account," according to this government official.

So, it may be that the $633 million that is missing from MF Global's customer accounts is money MF Global lost when it got whacked by margin calls on its stupendously risky bet on French and German bonds without any hedge. As Mf Global was under no obligation to inform customers their money was being risked on behalf of MF Global, this explains the mystery and outrage by investors and traders in Israel, Switzerland and across the US.

CFTC rules are a bit of sleight of hand. Rule 1.20 states very firmly that "all customer funds shall be separately accounted for and segregated as belonging to commission or option customers." Then, rule 1.25 lists all the acceptable investments that can be made, including foreign sovereign securities.

But, given the dangers of default in Europe, the CFTC was trying to exclude the ability to invest in certain risky securities like sovereign debt., To try and block this rule change, Corzine met with CFTC officials 10 times in the last year or so, according to the Sunlight Foundation in Washington, D.C., which is carefully monitoring all the proposed rule changes in the Dodd-Frank legislation, and making sure that all the infightimng by lobbyists for finance and banks is made totally transparent.

Corzine also wrote a letter to the CFTC in December 2010 arguing that to disallow commingling for the purchase of foreign bonds "will eliminate a liquid, secure, profitable and necessary category of investment."